Dividend Policy Theories: applicable to today's culture?

Dividend policy is “the determination of the proportion of profits paid out to shareholders – usually periodically” (Arnold, 2013). According to Portfield (1965) the aim of the dividend policy is to maximise shareholder wealth. To do so, the new share price should be equal to, or be greater than the previous share price. In comparison, Modigliani and Miller (1961) (M&M) argued that dividend policy is irrelevant to share value (with the assumptions that were mentioned in my previous blog). Their theory suggests that the determination of value is determined by future earning potential; and the pattern of dividends makes no difference to the acceptance of these. This indicates that the share price of a company would not change if the company declared a zero dividend policy or a policy of high near-term dividends (Baker, Powell and Veit, 2002).

Lets look at an example to illustrate this theory:

If this theory were to be true, then Morrisons share price would show no change when the Chairman announced on the 6^th March 2015 that the supermarket was cutting its dividends to help fund the turn around plan (The Telegraph, 2015). Figure 1 which I have created, shows that the share price was uneffected by this announcement. Although the market is not ‘perfect’ how M&M (1961) assumed, what this example does demonstrate it that when investors are aware that the cash retained will be going into a postive NPV project which will generate future dividend increases for shareholders, the share price is uneffected. However, some shareholders require dividends as a source of regular income, therefore Morrisons may see a decrease in a certain clientelle of shareholders (Watson and Head, 2013). Shareholders could sell a proportion of their shares to create ‘homemade dividend’ confident in the knowledge that a fair price would be obtained in this ‘perfect world’, which takes into account the additional value from the project (Arnold, 2013). Of course, as addressed in a previous blog, a perfect capital market does not exists, as transaction costs and taxes are very much real, therefore this theory is arguable inaccurate.    

Figure 1: Share Price of Morrisons. Figures from Yahoo Finance, 2015

M&M (1961) also argue that dividends represent a residual payment. Using the Morrisons example to illustrate, once Morrison's have provided funds for the turn around plan, investors should be given the residual. By receiving this cash, they can invest in other organisations of the same risk class which provide an expected return at least greater as the required return on equity capital (Arnold, 2013).

In this circumstance dividend policy becomes an important determinant of shareholder wealth:

•    If cash flow is retained and invested within Morrisons at less than the equity capital, shareholder wealth would be destroyed; therefore it would be better to raise the dividend payout rate
• If retained earnings are insufficient to fund the positive NPV turn around plan, shareholder value is lost, and it would be beneficial to lower the dividend.

In contrast, Gordon (1959) presented the “bird in the hand”argument which indicates that dividends are preferred to capital gains due to future uncertainty. As an investor, I would rather have my money now, than to leave it tied up in uncertain investments. With this in mind, it is clear to see that the dividend policy will influence the market value of a company.

Now lets look at an example to illustrate this opposing theory:

On February 6^th 2015, Norway’s Statoil announced that it would cut capital spending by $2 billion this year in preparation for an ‘extended period’ of low prices and volatility (Bloomberg, 2015). This announcement came after Statoil published that the net income for the quarter was $9 billion which was drastically lower than their estimations of $26 billion. However, the new CEO, Eldar Saetre ensured shareholders that the company is still “highly committed to the dividend policy”. The dividend rate will remain at a flat for the next 3 quarters, which he believes reflects the current market environment whilst remaining competitive (Bloomberg, 2015).

If Statoil are facing tough times, then why are they committed to their dividend policy? From a business point of view, the answer is simply. If Statoil had decided to pay a lower dividend, then their investors may sell their shares and invest in one of their competitors which are paying a higher dividend. This would result in a decrease in Statoil’s share price and therefore decrease the market value of the company (Watson and Head, 2013). What Statoil is doing is ‘signalling’ good news to their shareholders. The competitive dividend pay out is acting as an important conveyor of information (Arnold, 2013). Due to information asymmetry within the market, dividends are used as an indicator of a firm’s sustainable level of income. Even when faced with uncertainty regarding the price of oil, Statoil are indicating an optimistic view about their future, which should therefore not reduce investor’s confidence in the company. By looking at Figure 2, it is clear that this approach has been successful, as Statoil have been able to maintain a reasonable steady share price since the announcement.     

Figure 2: Statoil’s share price for the first quarter of 2015. Figures from Statoil, 2015

In comparison to M&M’s theory, as an investor I would be slightly concerned that by continuing to pay competitive dividends that Statoil may have limited positive NPV projects therefore may lower my future returns (Watson and Head, 2013). However, Saetre has clearly communicated that the company will continue to stay on track with its giant Johan Sverdrup field and other ongoing projects. I believe that by addressing shareholders’ concerns on Bloomberg Television’s “Countdown” demonstrates transparency therefore shareholders know exactly where they stand with Statoil’s future, which had also influenced the steady share price.     

   

In conclusion, although M&M’s (1961) theory is criticised due to assumptions that were made, I agree that in order for Morrison’s to make an effective turn around, dividends need to be reduced so there can be a concentration on investing in positive NPV projects. By thinking long term, this should increase shareholder wealth. However, if there is a residual once all projects have been covered, then I believe that the shareholders should receive that money. By illustrating this theory with the Morrison’s case, it demonstrates that when shareholders are aware of what the reduction in dividends are being invested in, then the share price remains relatively steady. Likewise, by effectively communicating what their plans are, Statoil have been able to maintain shareholder confidence which has resulted in a steady share price. Although they have not reduced their dividend policy, the recently published results could have affected the share price of the company, had they not effectively communicated their future plans and signalled a positive view for the future.       

References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson.O’Brien

Baker, H. K., Powell, G. E., & Veit, E. T. (2002). Revisiting the dividend puzzle: Do all of the pieces now fit?. Review of Financial Economics, 11(4), 241-261.

Bloomberg (2015) Statoil CEO Says `Highly Committed' to Dividend Policy. Retrieved from http://bloomberg.com 

Gordon M (1959), “Dividends, Earnings and Stock Prices”, Review of Economics and Statistics, 41, 99- 105.

Miller, M. H., & Modigliani, F. (1961). Dividend policy, growth, and the valuation of shares. the Journal of Business, 34(4), 411-433.

Porterfield, J. T. (1967). Dividend Policy and Shareholders' Wealth. Financial Research and Management Decisions, hg. von Alexander A. Robichek, New York, London, Sydney, 54-67.

The Telegraph (2015) Morrisons to slash dividend to fund rescue plan. Retrieved from

 http://www.telegraph.co.uk/finance/newsbysector/retailandconsumer/11455839/Morrisons-to-slash-dividend-to-fund-rescue-plan.html 

Watson, D. & Head, A. (2013). Corporate Finance: Principles and Practice. (6^TH ed.), Harlow: Pearson. 

Figure 1 - Figures from Yahoo Finance. Retrieved from https://uk.finance.yahoo.com/echarts?s=MRW.L#symbol=MRW.L;range=1d 

Figure 2 – Figures from StatoIl. Retrieved from  http://www.statoil.com/en/investorcentre/share/pages/historicshareprices.aspx

How much debt is too much debt?

The capital structure of a company refers to the mixture of equity and debt finance used by the company to finance its assets. The decision on what mixture to use is called the financing decision. (ACCA, 2009).

On February 25 2014, Bloomberg announced that Det Norske Oljeselskap ASA, the oil producer, was reviewing its funding options and looking to cut costs as a plunge in crude oil prices caps the cash flow it needs for new projects. A financial decision has been made that the company will increase their debt finance and may also be able to issue new shares. In essence, the company is trying to create the optimal capital structure, at the lowest possible cost to their shareholders (Bloomberg, 2015).

At this stage in my studies, I understand that financing a business through borrowing is cheaper and less risky than using equity; therefore it is unsurprising that companies, such as Det Norske, are increasing their debt levels. The benefits that companies can obtain through debt finance are as follows (Arnold, 2013):

•  lenders require a lower rate of return than ordinary shareholders
•  debt financing securities present a lower risk than shares because they have prior claims on annual income and in liquidation.
• a profitable business effectively pays less for debt capital than equity, as debt interest can be offset against pre-tax profits before the calculation of the corporation tax bill, thus reducing the tax paid.
• issuing and transaction costs associated with raising and servicing debt are generally less than for ordinary shares.

The traditional view implies that the market value is very much dependent on a company’s capital structure. It suggests that by increasing their debt finance, Det Norske would be financed to a greater extent by cheaper borrowed funds; therefore the weighted average cost of capital (WACC) would decrease (Arnold, 2013). A lower WACC, would result in a higher market value of the company, thus increasing shareholders wealth.

But is there such a thing as too much debt?

 

Put simply, yes. As debt begins to increase, Det Norkse will increase their chances of financial distress which could ultimately result in liquidation (Arnold, 2013). Although a successful company, if Det Norske is faced with a prolonged period of declining profits, the interest on the debt will still need to be paid, which may affect the company’s ability to pay dividends (ACCA, 2009). This increase in dividend volatility is a financial risk to shareholders. As a result, shareholders will require greater returns to compensate them for this risk, thus the cost of equity will increase, which will lead to an increase in the WACC. Furthermore, if profits are low, the company’s shareholders will find their returns declining to an exaggerated amount (Arnold, 2013). This research demonstrates that debt really is a ‘ball and chain’ for a company – there is no way to avoid payments, especially during a bad year.

What this argument identifies is that an increase in debt reduces the WACC, but it also increases WACC due to equity holders wanting higher returns. This demonstrates the complex relationship between debt and a company’s capital structure. 

However, in 1958 Modigliani and Miller (M&M) proposed an alternative theory by making some assumptions. Given these assumptions they concluded that the value of a firm remains constant regardless of the debt level. The WACC is constant as the cost of equity increases this is offset by the cost of the cheaper debt, and therefore shareholder wealth is neither enhanced nor destroyed by changing the gearing level, thus capital structure is irrelevant (O’brien, Klein and Hilliard, 2007).

 

In 1963, M&M revised their theory to include corporate tax and their conclusion altered dramatically. As debt becomes cheaper (due to tax relief on interest payments), the cost of debt decreases significantly (Watson and Head, 2013). This would mean a decrease in WACC (due to the cheaper debt) is now greater than the increase in WACC (due to the increase in financial risk); thus WACC falls as gearing increases (ACCA, 2009). If this theory is correct, this implies that Det Norske should gear up as much as possible, if they wish to reduce their WACC.

 

In contrast to both theories, which attempt to find an optimal capital structure, in this approach there is no search for an optimal capital structure. Companies simply follow an established pecking order which enables them to raise finance in the simplest and most efficient manner (ACCA, 2009) The order is as follows:

(1) use all retained earnings available
(2) issue debt
(3) issue equity, as a last resort.

 

I believe that companies should build up cash reserves in case of any future unforeseen expenses, which would reduce the amount of time spent on raising external finance to peruse new projects. 

 

So what is the best course of action for Det Norske to take?

 

Although increasing debt levels has its benefits, a company with excessive levels of debt could face huge implications, as outlined above.  I would discourage Det Norske from following M&M’s theory as I believe it would result in instability, as they failed to take into account bankruptcy costs, agency costs and tax exhaustion. In addition, M&M also assumed perfect capital markets in their theory, and as I discussed in my previous blog, this not true as prosecutions for insider information have taken place. I believe an optimal capital structure does exist, but is hard to define as each structure is unique to each individual company. Det Norske should consider what a “reasonable” level of debt is; based on the industry it operates in.

Additionally, although I do not support the pecking order theory, as I believe Det Norske should retain cash reserves, the company should not ignore the fact that the theory places debt higher than equity. This somewhat supports the traditional theory, that Det Norske should gear up, but once again, to a “reasonable” level to finance new projects.

References

ACCA (2009) Optimal Capital Structure. Retrieved from http://www.accaglobal.com/content/dam/acca/global/PDF-students/2012s/sa_junjul09_lynch.pdf

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson.O’Brien

Bloomberg (2015).  Billionaire Roekke’s Det Norske Reviews Funding as Oil Drops. Retrieved from  http://www.bloomberg.com/news/articles/2015-02-25/billionaire-roekke-s-det-norske-reviews-funding-amid-oil-drop

O'Brien, T. J., Schmid Klein, L., & Hilliard, J. I. (2007). Capital structure swaps and shareholder wealth. European Financial Management, 13(5), 979-997
 

Watson, D. & Head, A. (2013). Corporate Finance: Principles and Practice. (6^TH ed.), Harlow: Pearson.